They called him “Mr. Bubble.”

Since Irrational Exuberance, Shiller has published three other books. The most recent, and in many ways the broadest, is Animal Spirits, a collaboration with George A. Akerlof ’62, an economist at the University of California-Berkeley. Akerlof shared the 2001 Nobel Prize in economics, with A. Michael Spence and Joseph Stiglitz, largely for work that has come to be known as the “lemons” research. In Akerlof's portion of the research, he argued that the market for used cars suffered from an inherent flaw. The quality of used cars varied enormously, but only sellers typically knew which were the good ones and which were the lemons. Akerlof's essay on the subject, “The Market for Lemons,” was published in 1970. Five years later, Congress passed the Magnuson-Moss Warranty Act -- known as a lemon law -- which was meant to protect buyers of used cars.

Much like Shiller's work on bubbles, the lemons research challenged the basic idea of neo-classical economics: that markets generally function well. The discipline of economics concedes that markets have imperfections, but has long considered the flaws to be mere anomalies, which will be eliminated during the normal give-and-take of market transactions themselves. (This is the “invisible hand” of the markets, in Adam Smith's famous phrasing.) Yes, there might be the occasional dishonest used-car dealer, but he will be driven out of business because consumers will catch on to him. And, yes, there might be the occasional bubble, but it won't get too big. Investors, acting out of rational self-interest, will not let it happen.

Akerlof and Shiller disagree. They argue that flaws and excess are inherent to a market economy -- and that they are not minor. “The economics of the textbooks seeks to minimize as much as possible departures from pure economic motivation and from rationality,” Akerlof and Shiller write. “Our book marks a break with this tradition. In our view economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed.”

The common thread that runs through these deviations is human emotion -- or, as the early twentieth-century economist John Maynard Keynes described it, “animal spirits.” Over the past generation, a group of scholars, who have become known as behavioral economists, have helped change the discipline by pointing out just how important human emotion is. People are not, in fact, computers who analyze the offers sent by mutual funds or health clubs and always make the rational choice. (Advertising executives, it should be noted, have long understood this.) People are deeply affected by how the options are framed and how their ultimate decisions make them feel. They are driven, Akerlof and Shiller write, by trust and confidence, by notions of fairness, and by compelling stories about how the world supposedly works.

Shiller credits his wife, Virginia Shiller, for much of his evolution from a more traditional view of economics to a more behavioral one. She is a clinical psychologist at the Yale Child Study Center who, he says, has persuaded him that psychology is at the heart of economics. Psychology, not the hyperrational models of economics, helps explain why people continued to buy stocks in 1999 and Las Vegas condominiums in 2005. The buyers had come to believe the stories about how the future would be different. Dot-com companies didn't need to make profits. Home prices didn't have to be tied to the level of household income. It was a new era!

Shiller argues that these stories were compelling partly because they contained a nugget of truth. A market system -- that is, capitalism -- has in fact proven to be the most successful way to organize an economy. The U.S. economy continues to be the richest the world has ever known. Asian economies that have moved toward a more market-based system, like China, India, South Korea, and Singapore, have experienced phenomenal gains in living standards. Individuals left to their own devices usually make rational choices.

Yet over the past generation policy makers have come to assume that the departures from rationality are so minor as to be nearly irrelevant to government. “If we thought that people were totally rational, and that they acted almost entirely out of economic motives,” Shiller and Akerlof write in Animal Spirits, “we too would believe that government should play little role.” In recent years, no one came to embody the laissez-faire idea more than Greenspan. “Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief,” he told a congressional committee during a humbling appearance last fall. He had, he admitted, found “a flaw” in his theory.

Shiller has been arguably Greenspan's best foil over the past decade and a half. With the big bubbles largely gone, Shiller is now arguing for an approach to economic policy that takes animal spirits far more seriously. And it isn't just about bubbles.

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